Business

Shock to the system coming, economist tells Denver audience

Jacob Yzaguirre, left, works on an oil rig in Weld County in April. Economist Gary Shilling says any number of triggers could stall a still sluggish economy, including fighting in the Middle East, which would drive up oil prices. (RJ Sangosti, Denver Post file)

Investors should prepare for a financial shock this year, one that greatly reduces the appetite for risk, predicts Gary Shilling, a leading economist and president of A. Gary Shilling & Co.

"We are dealing with a system that is very fragile," said Shilling, addressing the 10th annual Forecast Dinner hosted by the CFA Society of Colorado on Thursday evening.

Shilling said it wouldn't take much to stall a still sluggish U.S. economy, although he doesn't know the exact trigger.

China's shadow banking system has accumulated massive debts and could crack as defaults rise. Emerging-market turmoil could worsen or more countries could throw up trade barriers. Fighting in the Middle East could spread, driving up oil prices.

Whatever the spark, Shilling said investors will flee riskier assets such as equities and commodities in favor of cash and U.S. Treasury securities.

Shilling gained fame in the early 1980s when he wrote "Is Inflation Ending?" and for persistent forecasts since of lower interest rates, which he argues could drop again as deflation takes hold.

Deflationary pressures will be most noticeable in commodities, including raw materials and energy, where a sharp rise in domestic production is boosting supplies.

Shilling notes there is a difference between "bad" deflation resulting from a sharp drop in demand as during the Great Depression and "good" deflation generated by productivity-fueled expansions in supply after the Civil War and in the 1920s.

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"We have a little bit of both right now," he said.

Businesses have boosted their efficiency, producing more goods at a lower cost, allowing corporate profits to claim a larger share of economic activity.

At the same time, labor's share of U.S. gross domestic product has shrunk, increasing income polarization and hindering consumer demand and the recovery.

"Workers' share of income and purchasing power is going down," Shilling said. "How can consumers increase spending in real terms without having the jobs and income to do so?"

A protest for an increase in the minimum wage takes place in Denver. "Workers' share of income and purchasing power is going down," Gary Shilling says. (Joe Amon, Denver Post file)

Powerful deleveraging forces are at work as households and businesses shed debt, overwhelming the Federal Reserve's massive debt purchases, which have done more to boost excess bank reserves than economic activity.

New Fed Chair Janet Yellen faces the difficult task of unwinding those reserves gradually enough to avoid triggering a recession but quickly enough to prevent inflation.

Shilling estimates she has about four years before the deleveraging cycle ends and stronger demand and hiring return. After 32 years of calling for disinflation and deflation, Shilling now raises the specter of a destabilizing inflation should Yellen fail.